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Initial Thoughts on Brexit and Custody

This is the fourth in a series of five thought pieces Thomas Murray wishes to share with clients this summer, the questions for our fields of expertise before the amorphous Brexit project takes shape.

In response to the 2007-2009 financial markets crises, and in line with G20 direction on restoring global economic growth, a primary objective of the European Commission was to shore up gaps in capital markets regulation wherever they were to be found. As regards custody, the partially overlapping segments of central securities depositories and custody banks have been subject to colliding regulatory purposes and often contradictory official projects – if confusing, this is somewhat understandable given that the two domains fall between capital market and banking legislation/regulation, each subject area with its own points of view. This still needs sorting out, and that clarification of duties and compliance will take place in the near background whilst the British exit from the EU is defined and executed.

Central securities depositories in the context of a future Brexit were highlighted in the previous posting in this series. This opinion looks at the first questions asset managers may need to consider.

Financial institutions providing custody services are a varied mix, depending on the degree of separation between the client and its assets and the complexity of the servicing required. One commonality is a banking license, but after that the differentiation is considerable. When an investment portfolio ends up with assets spread across the world, the servicing needed to support the owners leads to the creation of complex chains that can involve links amongst global custodians, national custodians, and sub-custodians. Each of these strata would have different responsibilities to the asset owners and their delegated portfolio managers, if usually indirectly.

For the purposes of this thought piece, Thomas Murray is focusing on the custody implications for asset managers, not the actual providers of custody services. The EU has prepared complex regulation for collective investment funds (UCITS), and trading itself (MIFID II). The obligations of funds managers to their clients with respect to potential custody problems have increased. We will look here now.

Compared with others in the 27 Continuing-EU countries, British-based firms and their customers benefit disproportionately from passporting across national borders; they account for three-quarters of the regional total. The public funds segment could be amongst Britain’s biggest losers in financial services post-Brexit, because as it is now structured the Directive does not cater for recognition of third-country regimes. UCITS regulation allows collective investment schemes (public funds) to operate and be marketed freely throughout the EU on the basis of a single authorisation from any member-state government. UCITS sets minimum standards; individual EU member-states can prescribe additional regulatory requirements if they would benefit investors. A future Britain outside the EU might consider reworking requirements in order to distinguish its protections to investors.

A fundamental requirement for a UCITS fund passport is that the fund itself should be domiciled in the EEA. Leaving the EU could mean that British-domiciled UCITS funds would no longer be permitted to be marketed or distributed within the Continuing-EU, and conversely, registered public funds domiciled in a Continuing-EU member state might no longer be allowed to be distributed in Britain. Certainly, there is nothing automatic about the continuity of current practice.

In order to benefit from the passport when Brexit takes effect, British funds management companies may have to move to a domicile in the Continuing-EU, or in some other manner they would have to re-register their funds to stay compliant with UCITS regulations.

This question has the potential to be extremely costly to this large British specialty. Funds managers may have to adopt a similar structure to US-based managers of funds compliant with UCITS regulation, which is to say arrange for delegated management of EU-domiciled funds, which have often been established in Luxembourg or Ireland. This would involve additional cost and considerable administrative burden. Continental asset management competitors, and certainly providers of services to public funds, may be able to wrest some advantage from their bases in the Continuing-EU.

Markets in Financial Instruments Directive (MiFID)

The second body of regulation affecting asset managers is MiFID, with the MiFID II update due for implementation in 2018.

MiFID enables UK banks and investment firms to conduct their capital markets business with clients and counterparties across the EU from a single hub location for the region. EU firms that seek to engage in the businesses covered under this Directive in Britain may no longer be able to do so; they may well have to restructure their operations, and those seeking to deal in Britain may well have the equivalent access question. Currently, on behalf of their buy-side clients, banks and investment firms in the UK have the right to apply for memberships of regulated markets, central counterparties (CCPs), and settlement systems on a non-discriminatory basis in the 27 other countries.

In line with the other directives and regulations coming out of Brussels these past years, MiFID II does provide for third-country regimes and the recognition of qualified firms for work in the EU. The inclusion allows non-European Economic Area (EEA) firms to provide investment services to professional clients on a pan-EEA basis upon registration with ESMA. This would not be an immediate solution, as this would be subject to ESMA making an equivalence determination under MiFID II in relation to the UK. The timing would be highly uncertain. MiFID II is not quite here yet, either.

According to the current schedule, MiFID II will need to be transposed into UK law by July 2017, and MiFID II and the Directive’s corresponding Regulation, MiFIR, will apply in the UK from January 2018 – looking at this matter from the perspective of August 2016, it is doubtful that the terms of EU withdrawal will be agreed before that date.

Whilst that date is unknown, it is a near certainty that UK firms will be compliant with MIFID II prior to their country’s EU withdrawal. Having gone through all the work to become compliant, and having played an active role in drawing up the MiFID II requirements, it is also likely that they will continue on the trajectory of MiFID II compliance for some time.

Based on this equivalence as all 28 countries move to MiFID II, it should be relatively straightforward for UK firms to continue to access the EU market as a third-country afterwards. Even then, access would only be partial: under MiFIR, this third-country concept does not apply to those firms doing business with retail clients – the third-country access provision is intended for institutional business only. Working with individual investors is instead meant to depend on the law of individual member states, unless it is carried out through reverse solicitation.

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The UK’s Referendum on membership of the European Union last 23rd June has set Britain’s financial services sector off on a path into the unknown, along with much of the rest of public life. The next article in this series will summarise the questions Thomas Murray will be asking itself as regards post-trade.